Considering an Unsecured Loan? Here Are All The Things You Need To Know

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While the name might sound intimidating, unsecured loans are a common form of borrowing. They include several types of debt, from credit cards to student loans, all with the same key feature: they are not guaranteed by any tangible assets.   

In order to get an unsecured loan, you do not need to put up any collateral, like a car or home. That’s how it differs from a secured loan, which requires that the borrower pledge an asset as security. With an unsecured loan, there is no asset for the lender to seize if you stop paying; only your creditworthiness determines whether you will get the loan, and under what terms.  

The Different Types of Unsecured Loans 

Unsecured loans are riskier for a lender, since there is nothing to repossess if the borrower defaults. Because of this, unsecured loans typically come with higher interest rates than a secured loan.

Types of unsecured loans include: 

  • Personal loans, which are paid in a lump sum and must be repaid over a given time; lenders have no control over how you spend the money. While interest rates on personal loans are higher than on secured ones, they are much lower than on credit cards. According to data from the Federal Reserve, the average interest on personal loans in the second quarter of 2020 was 9.50%, although you might qualify for a lower rate depending on your creditworthiness. The average interest rate for credit cards was 15.78%. 
  • Debt consolidation loans, which are a way to combine various other debts — typically unsecured ones —in one place, so you only have to make one monthly payment, generally at a lower annual percentage rate (the actual cost of repaying the loan). Note that there also are secured debt consolidation loans.    
  • Student loans, which usually have lower interest rates than personal loans. There are specific stipulations for their use, and different terms than a personal loan. Student loans can be obtained from the federal government as well as from private lenders.
  • Credit cards, which are a form of unsecured debt giving you access to a certain amount of credit without time limits, as long as you’re meeting your repayment obligations.  

Unsecured loans tend to be for smaller amounts compared to secured ones. The average balance of unsecured personal loans, for example, is $8,500, according to data collected by the St. Louis Federal Reserve

The proliferation of financial technology or “fintech” companies, which include many online-only lenders, has helped the unsecured loan market grow fast, mostly through a rise in personal loans. In 2019, there were 38.4 million personal loan accounts in the U.S., an 11% increase from the previous year. Because of the quick and easy application processes offered by many online lenders, fintech companies generate almost 40 percent of all unsecured personal loans, according to an estimate from credit monitoring company TransUnion in 2018.  

When an Unsecured Loan Makes Sense 

Unsecured loans “are accessible to most anyone who has decent credit, regardless of what they own,” says Nishank Khanna, Chief Financial Officer of New York-based online lender Clarify Capital.

Pro Tip

Talk to your lender in person. You can access loans completely online, but you might get a better deal if you have a one-on-one conversation.

You can get an unsecured loan from a variety of sources like local banks, credit unions, online companies, and so-called non-bank financial institutions or NBFIs, which include brick-and-mortar finance companies, insurance companies, peer-to-peer lenders, and other non-bank entities as well as fintech lenders.  

Major banks are cutting back on issuing unsecured loans right now, says financial attorney Leslie H. Tayne, author of Life & Debt and founder and managing director of Tayne Law Group in New York. As they evaluate risk amidst the economic uncertainty created by the coronavirus pandemic, they often consider unsecured loans too risky for all but the most qualified borrowers.

If you have poor credit, an unsecured loan from any of the above lenders would carry a relatively high interest rate — although one that will remain fixed for the life of the loan, unlike with credit cards. Unsecured loans also have origination fees, which can be 1% to 5% of the loan amount. 

You should also consider why you want to apply for the loan. If you’re simply looking to fund non-vital expenses you don’t currently have the money for, borrowing this way may not be a good idea: “If it’s living outside your means, a personal loan can just be a temporary stop-gap measure,” says Joseph Toms, president and CEO of Freedom Financial Asset Management in San Mateo, California.

If you default on an unsecured loan, meaning you don’t make your monthly payment for a period of 30 to 90 days, your loan can go to collections. This can drastically affect your credit score for up to seven years, says Jonathan Howard, a financial advisor with SeaCure Advisors in Lexington, Kentucky. This might also result in a lawsuit, with the collector trying to secure repayment — including fees and accrued interest — through wage garnishment. It might even result in an outcome that defies the original nature of an unsecured loan: The creditor may place a lien on your personal property.  

Getting Approved for an Unsecured Loan 

You’re more likely to get approved for an unsecured loan with a credit score at least in the high 600s, but scores in the 700s will guarantee you a better interest rate. 

Besides your credit score, you should also know your debt-to-income ratio. 

“Ideally, your monthly debt payments should not exceed 15% of your normal take-home pay,” Howard says.Another way to calculate the most unsecured debt you can take on, says Howard, is to “look at your annual take-home pay and make sure that your total consumer debt doesn’t exceed that number.” 

While applying for an unsecured loan is quick and easy online, Tayne is a proponent of having a human-to-human conversation with a lender, such as a local bank or a credit union, when shopping around for unsecured loans. Beyond more personalized service, they might potentially offer lower interest rates, especially if you have a low credit score; more flexible terms; and smaller loan amounts. 

Once you have a shortlist of potential lenders, Howard recommends getting pre-approved, requiring only a soft credit check — which does not affect your credit score — so you can compare interest rates and know the amount of the loan you’ll be approved for. Toms also suggests asking if the lender is offering any discounts, especially if you are applying with a co-borrower who can provide additional income guarantees, or if you have retirement savings.

Make sure you understand the terms of the loan, like the interest rate, any application fees or upfront costs, if there are penalties for prepayment of the principal, and what the payment terms are. For unsecured loans, it’s especially important to understand what happens in case you default, says Tayne.

The lender will also run a hard credit check, which will affect your credit score, before approving or rejecting the application. You’ll need to provide your Social Security number, a government-issued ID, and most likely proof of income. Depending on the lender, you could also be asked to provide an account of any outstanding debts and your employment history. To receive the funds, you’ll need to provide your bank account information for deposit. Once the loan closes, it might take up to a week for the funds to arrive, Howard says.

Alternatives to Personal Loans 

If you’re looking to borrow money, you may have options other than unsecured loans. That will depend on what you are using the money for, how quickly you need the funds, and what fees or other expenses you’re willing to pay. 

One option is opening a credit card with an introductory 0% APR on purchases and using it for the same expense that you would have with the loan — keeping in mind that you’ll need to pay the balance off during the promotional period, or you will pay the interest charged by the card, which will likely be higher than the interest on a personal loan. 

If you’re using an unsecured loan for debt consolidation purposes, you could consider a balance transfer credit card instead, one offering no interest for a promotional period that can be as long as 20 months. But here, too, if you do not pay off the balance before the 0% APR period expires you’ll end up paying high interest rates.     

If you have an asset, like a home or vehicle, to pledge as collateral, you can opt for a secured loan instead. If you have enough equity built up in your home, you can borrow against your house in the form of a home equity line of credit, which you can do if you have at least 20% equity,  or a home equity loan. Another option if you have good credit is a cash-out refinance on your home. 

You can also borrow against your retirement savings account or 401(k) as an alternative to an unsecured loan. Ordinarily, this would be inadvisable because of the penalties and taxes associated with taking money from your retirement funds, but Congress has waived them with the CARES Act passed earlier this year. That means you can take a loan up to $100,000 or 100% of your vested account value, whichever is greater, without paying the penalties you normally would. That only applies, however, to people affected by the coronavirus, and comes with stringent conditions.  

Bottom Line

People looking to borrow money in a lump sum with no collateral have a variety of options. If you have good credit and are looking to repay the money in the short term, an unsecured loan may be the right option for you. Shop around for the best interest rates — but do not let the ease of applying for a loan online push you into borrowing money this way if you are not in a financial position to do it. 

Further Reading

We’ve written extensively about loans, including personal loans, and debt management. You can find some highlights of our past coverage below.

Personal Loans

Debt Management